why ... isn't [ there ] mass unemployment when bubbles are growing as well as shrinking -- why didn't we need high unemployment elsewhere to get those people into the nail-pounding-in-Nevada business?

His point is, on balance, both booms and busts involve the
reallocation of resources, yet only busts seem to produce mass
unemployment. While Krugman and Arnold Kling* are wrapped up in a
debate about how the question influences our understanding of
government stimulus, I'd like to simply offer up an answer.

For any fixed amount of capital available for investment, an
increase in the amount of capital allocated to one area implies that
the amount of capital allocated to some other area must have decreased.
In short, capital allocation with a fixed amount of capital is a zero
sum game. The same is true of society's capital. If the pie doesn't
grow, but stays fixed, and society shifts more of its capital into one
area of economic activity, it necessarily implies that we have taken
capital away from some other activity.

Asset bubbles, however, are, according to my theory of the world,
able to temporarily increase the amount of capital society has
available for investment because of the effect that asset bubbles have
on the market's expectation of incurring losses on investments tied to
the bubble-asset. Some of the capital that society has available for
investment is held back by the market in cash or cash-like investments,
such as short term Treasuries, in order to cover potential losses that
might arise from investments. Some entities, such as banks and
insurers, are subject to regulations that dictate how much capital must
be set aside to cover these potential losses. Other entities are free
to estimate the amount of capital that needs to be held back in order
to cover these losses. So, if we took a snap shot of all of society's
capital available for investment at a given point in time, some portion
of that would be withheld as a loss reserve in cash or cash like
investments. That means some portion of the capital available for
investment isn't really being allocated to "investments," but being
withheld to cover potential losses on bona fide investments.

Asset bubbles create value out of thin air. Price trends develop
that deviate sharply from historical norms, and eventually a new,
albeit temporary, norm is established. As a result, asset bubbles make
the bubble-asset look like a much better investment than it will
eventually turn out to be in the long term. As such, asset bubbles
create capital available for investment out of thin air because they
cause the market to underestimate the amount of capital that has to be
set aside to cover potential losses arising from investments tied to
the bubble-asset. This means that the effective pie, the portion that
actually gets invested in non-cash assets, can be temporarily expanded,
removing the zero sum accounting restriction, simply because less of
society's resources are used to cover losses.

When homes across the U.S. all started increasing in value more or
less in tandem, home owners felt, and in fact were, richer than they
were the day before. They could access the newly found equity in their
home to purchase other goods, or double-down and purchase yet another
home. As this process escalates and apparent price trends develop,
banks feel more confident in making loans tied to housing and begin to
compete for those loans. Mortgage lending, which was traditionally
considered a "safe" lending business, got even more "safe" since the
value of the collateral would surely continue to increase over the life
of the loan. So even if the borrower lost his job or his legs, he could
always sell the house to cover the loan: there will surely be plenty of
equity between the face value of the loan and the price of the home
upon sale. And so as lenders' expectations of an upward trend in price
becomes more entrenched, lenders become willing to lend greater amounts
of money tied to real estate and can do so without subtracting from
other lending activities by simply reserving less capital for losses on
their real estate lending.

So what happens when bubbles pop? Once losses exceed expectations,
the market is forced to reallocate its capital to cover those losses or
face insolvency. If the price of the bubble-asset drops far enough,
this could force fire sales outside the bubble-asset market as firms
scramble to cover their liabilities. Once this happens, economic actors
have less access to capital than they did before the bubble got
started, leading to a sharp contraction in economic activity and
concomitant upticks in unemployment.

One thing that still puzzles me is why bubbles pop when the
bubble-asset isn't usually expected to produce a cash flow. For
example, capital invested in internet companies (e.g., internet stocks)
should at some point generate the return that everyone was expecting.
When internet startups don't generate positive cash flows, those
returns fail to materialize en mass, and that's a clear signal to the
market that its expectations were off. And so the bubble pops. But what
sort of return were people expecting from housing? What was the signal
that caused the bubble to pop? Clearly, defaults on bonds backed by
real estate were the signal to the capital markets, but what caused the
price plateau in the underlying housing market that got the defaults
rolling? Was it that credit was extended to the maximum extent
possible, and so no further appreciation was possible? Or was the cause
psychological, a sort of vertigo price point at which both lenders and
borrowers lose their nerve?

*Arnold Kling
has proposed an alternate explanation involving the timing of bubbles,
arguing that bubbles are gradual while busts are sudden, and that's the
cause. While shocks to expectations are generally bad for markets, I
think that this explanation is intellectually unsatisfying because (i)
it doesn't explain why busts are sudden and (ii) it tacitly assumes
that sudden changes create unemployment, which is probably true, but is
merely descriptive and not explanatory.

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